March 31, 2022

The 5 Minute Guide on How Life Insurance Works

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Insurance can seem intimidating. It doesn’t have to be. Check out our quick guide for everything you need to know about life insurance and how it works.

Most people view life insurance as a necessary evil. That’s because we’ve been led to believe it’s a daunting decision, where you have to choose between living in the moment or worrying about what will happen when life insurance kicks in – an uncomfortable exercise at best.

But what if we told you it doesn’t have to be that tough? Just hear us out.

Life insurance protects your family against a loss of income when you die, but it also makes good sense to buy it when you’re healthy and thriving. 

Not only can life insurance help you pay down your mortgage and cover your debt, but at Walnut, it can benefit your day-to-day life (yes, while you’re alive!), so you can enjoy the things that matter to you most with peace of mind about your financial security. 

Protecting the people you love and the things you work hard for are a key part of financial planning. So hitting major milestones like getting married, starting a family or business, and buying a new house are all reasons to look into life insurance.

But before choosing how much life insurance to buy and crunching numbers on a term life insurance calculator, you’ll need to understand how it works, who it impacts, and how to get the payout. 

Here’s everything you need to know about life insurance in five minutes.

The basics

Like car insurance, life insurance is a type of contract where you agree to pay monthly premiums to cover your risk of dying over a period of time. If you pass away during that period, your insurance company will pay out a death benefit to your beneficiaries (those you name as recipients).

However, there are certain types of risks that insurance companies won’t cover, such as non-insured hobbies (like skydiving). At a basic level, life insurance is split into two different options: term life vs. permanent life.

How insurance payouts work
Who should your beneficiaries be, and how will they receive the money?

Who you name as a beneficiary – or recipient of your insurance payout – is totally up to you. The most common beneficiaries are your spouse, business partner, or family members like parents, children, or siblings. 

While some insurance companies have limits on how many beneficiaries you can list, most policyholders choose a primary and secondary beneficiary, where they’ll assign portions of the benefit to split up.

If you have children written into your insurance policy who are under 18 at the time of your death, they won’t receive the payout until they reach the legal age. Until then, your insurance company holds onto the payout.

What happens if you are alive when your policy ends?

If you outlive the period of your insurance policy, you can either extend your coverage by adding on additional years or buying a new policy. Either way, updating your term will usually result in a higher monthly premium because you’re alive longer than expected and are older, maintaining more risk.

How to file an insurance claim and begin the payout process

Death benefits don’t typically automatically kick in from a life insurance policy when the insured person dies. 

When an insured person dies, the beneficiaries named have to file a claim with the insurance company to receive their payout. To claim the payout, you’ll need to show the insurance company your loved one’s death certificate. Most claims are paid out in a couple of weeks, but this process can take longer depending on the company. 

But what if you don’t know if you’re a beneficiary? How will you find out? 

Most of the time, the insured will tell you since you have a relationship with them, but sometimes policyholders don’t get the chance to share those details. 

Generally, insurance companies will inform you when the policyholder has died, but there are many ways to check, such as asking other family members, searching for the insurance policy, and sorting through the deceased’s paperwork (assuming you have the authority to do so).

Do you have to pay taxes on the life insurance payout?

Generally speaking, as a beneficiary, you don’t need to pay taxes on the money you receive from a death benefit, since it’s not recognized as taxable income by the government. 

However, there are some scenarios where you may be taxed:

  • If you choose to receive the payout at a later time (and the payout is held by the insurance company)
  • If you invest the payout in the stock market and the amount from the benefit triggers capital gains
  • If a death benefit is paid to an estate that will eventually be inherited by a person, they’ll need to absorb the estate fees and taxes

What are the ways beneficiaries can receive their insurance payout?

Beneficiaries can choose from a range of options to receive their insurance payout.

  • Lump sum: the total amount of money received as a tax-free one-time payment. Most people prefer this method as it gives them financial security quickly and lots of flexibility.
    Note: Canadian banks only insure balances up to $250,000 (under the Canada Deposit Insurance Corporation or CDIC), so if your insurance payout amount exceeds this, it may be a good idea to separate funds into various accounts to ensure full coverage.
  • Installments: where an insurance company breaks up the payout to the beneficiary over time as a monthly income or annual salary. This option ensures you don’t run out of cash too quickly, but you may be subject to interest on taxes.
  • Annuities: an income payout where beneficiaries receive payments as long as they’re alive. But any remaining amount left over when the beneficiary dies goes back to the insurance company.
  • Retained asset accounts: money can be put into an interest-bearing account where beneficiaries can dip into the cash as they need, with any interest earned being taxable. This method guarantees CDIC insurance, even if the balance in your account exceeds $250,000.

The final word on life insurance

Life insurance is also a powerful financial tool that most of us underestimate. 

Working life insurance into your financial plan as early as possible can help you fill a financial void in the lives of your loved ones after you pass away. That’s why we recommend having these conversations with your beneficiaries while you’re alive to ensure they understand what their options are. 

At Walnut, we make life insurance easy with our transparent subscription plans, instant coverage, and holistic benefits that support your daily life.

Start living your best life today.

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